Center for Business and Public Policy
at the University of Illinois, Urbana-Champaign

Economists know there is No Free Lunch.  Nowhere is that more true than in financial markets.  Indeed, if I had to pick a single lesson in financial economics that is more important than any other, I would go with something along the lines of “if you are already holding an efficient portfolio, then you cannot generate higher expected returns without taking on more risk.”  

Yet, time and again, we see individuals and public policy makers act as if this were not the case.  This is especially true for managers of state pension funds.  The latest case – the State of Wisconsin Investment Board.  According to the Wall Street Journal, the Wisconsin public pension funds “are turning to one of the oldest investment strategies – using borrowed money to boost performance.”  In essence, they want to increase the leverage of their pension portfolio by borrowing money and investing it. 

You might be thinking “Leverage? Isn’t that what partly got us into the recent financial crisis?”  Yes, of course it is.  And that should definitely concern Wisconsin taxpayers. 

Let’s think about what SWIB officials are trying to do.  According to a story in Pensions and Investments on January 11, officials want to reach an investment portfolio that is 120% of plan assets by the year 2012. 

If you think about this for 2 seconds, you realize that this emperor has no clothes.  Consider a simplified example in which I have a $100 portfolio.  I invest $60 in stocks, and $40 in bonds.  Now, I borrow $20 by issuing a bond.  If I invest the $20 of bond proceeds in someone else’s bonds, then I now have $60 in stocks and $60 in bonds.  Therefore, it appears I have reduced my equity allocation from 60% to 50% of my portfolio, and that will reduce the standard deviation of my portfolio.

Of course, this only holds true if I ignore the $20 of debt.  If I account for it in my analysis, then my true portfolio allocation has not changed – I still have the same $60 equity allocation, and my NET bond portfolio is still $40 (I own $60 but owe $20).  If the risk / return characteristics of my own bond match those of the bonds that I purchase, I have done absolutely nothing to my portfolio! 

Of course, Wisconsin is unlikely to invest in identical bonds.  They might invest in bonds with different risk/return/maturity/liquidity characteristics, but if so, then all they are doing is trading off returns for some form of risk. What Wisconsin appears to want to do is simultaneously alter their overall investment allocation.  But the same basic lesson applies – they are simply trading off risk and return.  

To suggest that borrowing and investing creates value is inconsistent with both elementary and advanced financial market theory, principles and empirical evidence.  The best financial engineer in the world can not build a financial free lunch.  

So to Wisconsin taxpayers, I say “beware.”  You can dress up misleading financial alchemy as a sophisticated investment strategy, but dressing up a pig does not change the fact that it is still a pig.   

The worst of it?  Steven Foresti, managing director of Wilshire Associates, is quoted in the P&I piece that “we think this is the direction institutions will go.”  Personally, I hope that Wisconsin sticks with exporting cheese, rather than bad investment policies.